Economics and the mid-life crisis have much in common: Both dwell on foregone opportunities

C'est la vie; c'est la guerre; c'est la pomme de terre . . . . . . . . . . . . . email: jpalmer at uwo dot ca

. . . . . . . . . . .Richard Posner should be awarded the next Nobel Prize in Economics . . . . . . . . . . . .

Tuesday, March 29, 2005

David Ricardo and the Social Security Crisis

The simple form of the theory of Ricardian Equivalence holds that if gubmnts borrow more now to spend more now, private individuals will save more now to meet their increased future tax obligations (or the increased future tax obligations of their heirs).

If individual decision-makers have rational expectations, then people in Canada and in the U.S. should recognize that future gubmnt-provided pensions (Social Security in the U.S., Canada Pension Plan in Canada) will have to be reduced and/or taxes will have to be increased to cover the increased pension entitlements of an aging population. Following the theory of Ricardian Equivalence, if people expect increased taxes or reduced benefits in the future, they should be expected to respond by saving more now and all this increased present-day saving will be in private pension accounts and savings plans.

It is not happening, though. People are spending more and saving less, as a percentage of their incomes. One reason is that many of us do not have rational expectations -- there are people telling us there is no reason to expect a future tax increase and/or benefit reduction. Furthermore, there is no way for people who believe there will be higher future taxes to bet with those who doubt it -- i.e., there is no way for these disagreements to be resolved in the marketplace.

Another reason is that many of us do not care about future generations. I have written before about how odious AARP is in its "pay us now and to hell with future generations of seniors" policy prescriptions.

Fifteen years ago, a colleague asked me, don't you start to save more when you see that the deficit is getting larger? My answer was [slightly tongue-in-cheek, to capture what I believed was prevailing thought, and to be provocative], "No, if I save more, the gubmnt will just have more to expropriate from me in the future. But if I don't have anything left, those of you who have saved will have to look after me." I expect this type of reasoning is still in place for many people.

(At one point everyone at The University of Western Ontario was expected to believe in what I referred to as "rationalized expectorations and overlapping generalizations"),
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